31.3 How Government Borrowing Affects Private Saving - Principles of Economics 3e

Learning Objectives

By the end of this section, you will be able to:

Apply Ricardian equivalence to evaluate how government borrowing affects private saving
Interpret a graphic representation of Ricardian equivalence

A change in government budgets may impact private saving. Imagine that people watch government budgets and adjust their savings accordingly. For example, whenever the government runs a budget deficit, people might reason: “Well, a higher budget deficit means that I’m just going to owe more taxes in the future to pay off all that government borrowing, so I’ll start saving now.” If the government runs budget surpluses, people might reason: “With these budget surpluses (or lower budget deficits), interest rates are falling, so that saving is less attractive. Moreover, with a budget surplus the country will be able to afford a tax cut sometime in the future. I won’t bother saving as much now.”

The theory that rational private households might shift their saving to offset government saving or borrowing is known as Ricardian equivalence because the idea has intellectual roots in the writings of the early nineteenth-century economist David Ricardo (1772–1823). If Ricardian equivalence holds completely true, then in the national saving and investment identity, any change in budget deficits or budget surpluses would be completely offset by a corresponding change in private saving. As a result, changes in government borrowing would have no effect at all on either physical capital investment or trade balances.

In practice, the private sector only sometimes and partially adjusts its savings behavior to offset government budget deficits and surpluses. Figure 31.6 shows the patterns of U.S. government budget deficits and surpluses and the rate of private saving—which includes saving by both households and firms—since 1980. The connection between the two is not at all obvious. In the mid-1980s, for example, government budget deficits were quite large, but there is no corresponding surge of private saving. However, when budget deficits turn to surpluses in the late 1990s, there is a simultaneous decline in private saving. When budget deficits got very large in 2008 and 2009, there was another a rise in saving. When the deficit increased again in 2020, saving jumped up as well. A variety of statistical studies based on the U.S. experience suggests that when government borrowing increases by $1, private saving rises by about 30 cents. A World Bank study from the late 1990s, looking at government budgets and private saving behavior in countries around the world, found a similar result.

This graph illustrates two lines: gross private savings and budget deficit or surplus as a percentage of GDP, over time. The y-axis shows the percentage of GDP, from –20 to 35, in increments of 5 percent. The x-axis shows years, from 1980 to 2020. The two lines generally move in opposite directions, as the government budget deficit increases, meaning the line becomes more negative, gross private savings increases, and as the government budget deficit decreases, meaning the line becomes more positive, gross private savings decreases. Gross private savings is always positive and is above the budget deficit or surplus line. It starts in 1980 at around 22 percent of GDP, and fluctuates over time between 17 and 25 percent, until 2020. It peaks in the mid-1980s at around 25 percent and is at a low of around 15 percent in 2000. The budget deficit or surplus line is nearly always negative, representing a budget deficit. In 1980 it starts at around –2 percent of GDP, decreases to –5 percent in 1985, then increases to positive 1 percent, a budget surplus, in 2000, which corresponds to when gross private savings is at its lowest. The budget deficit or surplus line then decreases to deficit, reaching –10 percent in 2009, which is when gross private savings is at one of its peaks of 25 percent. The line remains in a deficit until 2020. The line increases to –2 percent in 2015, corresponding with a decrease in gross private savings, then the line decreases, and the deficit increases, to –15 percent in 2020. In 2020, gross private savings spikes to 30 percent.

Figure 31.6 U.S. Budget Deficits and Private Savings The theory of Ricardian equivalence suggests that additional private saving will offset any increase in government borrowing, while reduced private saving will offset any decrease in government borrowing. Sometimes this theory holds true, and sometimes it does not. (Source: Bureau of Economic Analysis and Federal Reserve Economic Data)

Private saving does increase to some extent when governments run large budget deficits, and private saving falls when governments reduce deficits or run large budget surpluses. However, the offsetting effects of private saving compared to government borrowing are much less than one-to-one. In addition, this effect can vary a great deal from country to country, from time to time, and over the short and the long run.

If the funding for a larger budget deficit comes from international financial investors, then a trade deficit may accompany a budget deficit. In some countries, this pattern of twin deficits has set the stage for international financial investors first to send their funds to a country and cause an appreciation of its exchange rate and then to pull their funds out and cause a depreciation of the exchange rate and a financial crisis as well. It depends on whether funding comes from international financial investors.